There exist a number of marketplaces for financial or commodity assets that are not organized on exchanges such as the New York Stock Exchange or the Chicago Board of Trade. Rather, these markets are more fragmented, “over-the-counter” (OTC) markets. Some of the largest markets in the world, such as the markets for U.S. Treasury Bills, Notes, and Bonds, are not exchange traded and instead are typically served by market-makers who are dealers in the securities or commodities, and provide markets to customers who are not themselves market-makers. Market-makers (“Dealers”) also deal with each other in order to manage their market risk and inventories of tradable assets. Trading activity in such markets can be broadly divided into two segments: (1) Inter-dealer trading, and (2) Dealer-to-customer trading. For example, The Federal Reserve Bank of New York reports the trading activity of Primary Dealers in U.S. Treasury securities in two categories: Transactions with Interdealer brokers; and Transactions with Others.
Dealers and customers (“Clients”) of Dealers traditionally trade with each other in non-exchange based markets. The non-exchange markets allow the Clients to inquire on prices of particular assets from Dealers and choose whether to trade the assets at those prices. Sometimes a Client will receive a price and then negotiate further to reach a final price. In this context, clients are often referred to as “price-takers” and Dealers as “price-makers.” One of the reasons for an inquiry-based behavior is that away from an exchange, market pricing is not entirely transparent to all parties. Clients need to make inquiries to discover with certainty prices available for trading a particular asset.
Even with electronic innovations in Client-to-Dealer trading, the marketplace has largely remained bound to traditional patterns of Client-to-Dealer relationships. Electronic Client-to-Dealer trading of U.S. Treasury and Corporate bonds, for example, typically takes the form of inquiries sent by a Client to one or more Dealers. Dealers typically respond with prices that are executable for certain periods of time, and the Dealers may update these prices for a limited period of time as part of their response to the inquiry. Electronic trading has improved the efficiency of the price discovery and trade settlement processes, but has not fundamentally changed the dialog of the trading process. Some systems do permit Clients to send an order with an executable price to a Dealer. In these the Dealer is authorized to execute a trade without further communication with the Client, but with limitations such as the number of dealers that may be utilized and/or the time period for executing the order.
Electronic innovations have proceeded in parallel and separate paths in the two separate market segments of interdealer trading and Client-to-Dealer trading. Interdealer trading in large liquid but non-exchange traded markets such as spot foreign exchange, and U.S. Treasuries may utilize fully electronic cross-matching systems operated by interdealer brokers whose operation resembles that of electronic futures exchanges or equity electronic crossing networks (“ECNs”) even though they are not actually exchange markets. These fully electronic interdealer broker (“IDB”) markets provide continuous liquidity and an executable quality level of transparency. That is, it is possible to see levels with associated quantities that actually can be executed in real-time over a continuous period of time for those quantities shown.
Electronic trading systems in Client-to-Dealer trading on the other hand, particularly multi-dealer systems, do not provide continuous liquidity and full transparency. Systems that do provide continuous liquidity do so only at levels fixed by the Dealer(s) and do not allow the Client to specify their own price to for the purpose of continuous order matching. Transparency is typically limited to indicative levels that may or may not show quantity information. These pricing levels may be near executable levels and updated frequently, or they may be periodic updates such as twice a day. Clients send an inquiry when they have a trading interest, such as to buy bonds, and typically dealers respond with prices that are good for a short period of time (e.g., a few seconds) that may automatically update in order to slightly extend the period of time that prices are available for execution. Frequently, upon receiving an electronic inquiry, the Dealer automatically responds to the Client with an executable price. The executable price can be generated using a process that utilizes third-party market data such as prices from the electronic IDB market and proprietary data such as the Dealer's database of pricing relationships. The database can include pricing relationships between more liquid benchmark securities and less liquid securities that are priced based upon the levels of the benchmark securities.
Clients obtain reasonably competitive execution by sending inquiries to multiple dealers and comparing responses when they return. This execution, however, is competitive only for the instant in time when the client sends the inquiry. The timing characteristics of such inquiry models do not directly support more “patient” trading strategies that are considered a vital part of trading on exchanges, or even in trading in the IDB markets for non-exchange based products. Patient trading sacrifices the certainty of immediate execution for the possibility of achieving a better price through the general volatility of the market. Patient trading also gives Dealers the ability to find more matching interests that may enable them to fill a Client order with less risk and possibly cost to themselves; producing a more favorable trade execution for the Client.
There are a variety of reasons for the separate nature of the electronic IDB markets and electronic Client-to-Dealer trading. IDB markets are typically anonymous and often clear their trades through a central netting counterparty in order to reduce cost and risk for market participants. Clients often do not wish to trade anonymously because they prefer to know their counterparty, and Clients are often not eligible to participate in central netting arrangements. This is especially true when such nets involve mutualization of risk which institutional investors, such as mutual funds, are not typically permitted to engage in by their own bylaws. Thus, Client-to Dealer trading systems do not provide the Client with the quality-of-execution benefits of the fully electronic IDB systems such as access to continuous liquidity, transparency, trade matching opportunities, while at the same time retaining the desired characteristics of traditional Client-to-Dealer trading such as the flexibility to execute non round-lot amounts and the ability to trade on a disclosed relationship basis.